Thursday, October 23, 2008

OPEC countries are convening a meeting to discuss a coordinated decrease in oil production. The reason for this hastily convened meeting to decrease production is the steep and quick drop in the price of oil. Where it was at $147/barrel back in July, it is now at $67. An $80 drop in a matter of 3 months! OPEC nations are rightfully concerned.

But concerned enough to cut back on oil production? With the express motive of, not merely stopping the price drop, but bringing it back up? We know that Iran and Venezuela want to bring it back up to at least $100/barrel. They need it at that level in order to finance their respective domestic budgets. Any lower, and they are in danger of a fiscal crisis.

How did they arrive at their fiscal budgets? Oil only reached $100/barrel level at the start of this year. Did they automatically assume that that price level justified a suddenly bloated budget? Now that demand destruction has achieved the price declines that we are now seeing, these countries are panicking. And therefore want to bring it oil price back up to that level?

Before I explain why attempting to bring the price of oil back up is a big mistake, let’s go back to my first discussion on demand destruction. If the price of a commodity goes too high, many market participants will simply buy less, either by looking for close substitutes, or foregoing consumption altogether. In short, the price will eventually settle at a level where the market is able and willing to pay for oil.

The demand that is destroyed is not necessarily that coming from the most frivolous users. The demand that will be first to disappear is that coming from those whose purchasing capability is most stressed by the high price. It is they whose marginal propensity for oil consumption is steepest. As I had expected, the first to cut back on demand were:

1. The poorest people, i.e., those from the developing countries2. Companies the world over with the lowest profit margins3. Organizations that have only a fixed level of money for expenses, i.e., non-profits, NGOs, charitable organizations, municipal governments, etc.

Now that we are entering a severe global recession, the increased squeeze from artificially induced oil prices will no longer result in a cutdown on excess demand. It will result in a cutdown on crucial demand - from large and nationally-relevant industrial and business users necessary to keep global commerce from completely grinding to a full stop. Many of these are already reeling from an inability to secure adequate credit to buy their oil.

Higher oil price means less industrial production in many countries. Less industrial production means less jobs. Less jobs means lesser consumption. Lesser consumption means lesser production for still other countries who supply the originally destroyed consumption. And so on and on.

So let me repeat my warning back then - If governments, OPEC included, do not effectively manage the process of demand destruction, we may all end up with no demand at all.

Iran and Venezuela, just think what a possible absolute halt in demand for your oil would do to your respective budgets. Your problem will no longer be just a matter of selling your goods at a lower price, it would not being able to sell any significant amount at all. The complete breakdown in many national economies due to your moves will be on your conscience. And the wrath of your fellow OPEC members, who will also very likely suffer from such a breakdown in demand, will be all over you.

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.